Capital Exports during the Victorian Period

The large proportion of Britain’s wealth invested abroad between 1850 and 1914 has often been held to have been detrimental to the growth of the economy in this period. Examine the case for and against this argument.

Between 1860 and 1914 net foreign investment averaged 1/3 of national income with net overseas assets forming 7% of national income in 1850 which more than quadrupled to reach 32% by 1913 (Edelstein). Contemporaries of the time along with recent economic historians have speculated that this vast amount of capital being sent abroad was detrimental to domestic growth believing that if the capital had instead been invested at home Britain would have seen more rapid growth. We will explore these arguments to find that whilst capital exports may have been slightly too excessive during the period, it didn’t cause a huge impact on domestic growth.

Kennedy is one of the main proponents of the view that too much capital exported abroad was harmful to British growth claiming that a sensible reduction in capital sent abroad would have raised national income by between 25-50% over the period 1870-1914. Using McCloskey’s output growth equation:


and McCloskey’s estimates for these variables (λ=0.012; α=0.44; β=0.52;  = 0.0143; =0.102) we find that the output growth in the domestic economy between 1872-1907 was 2.4% per year but we need to evaluate whether this was the limit imposed by the economy’s available resources by using estimates of the capital-output ratio where a higher capital-output ratio reduces the growth of the capital stock, ceteris paribus. Feinstein calculated that on average, the capital-output ratio was at 4% which gives us the result that =2.6. Given that the savings ratio was around 10.4% for the period we find that the economy had the potential – according to Kennedy – to be growing at 3% per year, and not 2.4%, thus providing us with the result that over the entire period national income could have been 25% higher. Within these figures we have to assume that there was quite a lot of spare capacity, for example in the labour market. Whilst unemployment was around 6-7% (according to trade union data) Clapham claims that “a relatively small diversion of resources from foreign to home investment would soon have wiped out the few percent of extra unemployment”.

McCloskey disagrees with Kennedy, and believes that the economy was operating at its potential. She claims that there were diminishing marginal returns to capital being held at home, satirically pointing out that “by keeping savings at home, the British people could have had two Forth bridges, two Bakerloo lines, two London housing stocks, two Port Sunlights”. This point highlights the fact that there is only a limited number of investment projects available within Britain, and if capital was completely invested at home that the rates of return on these projects would diminish over time. Moreover, if firms faced lower returns as a result of a glut in funding sources, then they may have been inclined to undertake riskier and/or less profitable projects, due to the cheapness with which they could obtain funds. If this wasn’t an efficient use of the capital then incomes would have actually fallen. Hayek rejects this claim, saying that capital as an improving extension to existing capital can actually posses increasing returns to scale, e.g. finishing a half-built railway. We would also need to assume that there was constant technology for there to be diminishing rates of return: more investment at home may have boosted technology which would have led to further capital developments with higher rates of return.

Despite this McCloskey still has a valid point that investors would send their money where returns were highest. Although the data depends on the exact years we look at, which lead to Kuznet investment cycles, the average return on British investments was 10.8%, 13% in Empire and 9.4% foreign. It is obvious that if money was being sent abroad then it must have been because returns were higher and thus national income was higher as a result of these income inflows back to Britain. In assuming that the nation would benefit so long as investors were rationally putting their money where returns where highest we have to assume that social and private returns were aligned. Davis and Huttenback prevent a problem here, because they discover that firms operating in Empire countries received an indirect subsidy from British taxpayers through (practically) free defence along with other benefits. This means that these firms are able to provide a higher rate of return because they have lower costs; they find that if colonies didn’t receive this implicit subsidy then the returns would have been lower by about 1-3 percentage points. It could therefore be argued that too much was being sent to Empire because of these distorted returns, but when qualifying this it is important to remember that Empire only received 2/5 of British capital sent abroad and even with this, only a small amount would have been reduced.

Keynes argued that capital being sent abroad was detrimental because if a foreigner defaulted then the capital would be lost to British interests forever, whereas at least if a domestic borrower had defaulted within Britain, we would still benefit from the accumulation of physical capital. Unfortunately this is a weak argument because Keynes assumes firstly that the physical capital within Britain could be used by any firm; it might have been the case that its function was specific to the firm and thus unusable by other companies, secondly he omits the situation whereby if a foreigner defaults, the physical capital can still be sold and the income raised returned to the British lender, and thirdly the argument is insignificant according to Cairncross because default on British loans were rare.

So far we have Kennedy claiming that national income could have been 25-50% higher whilst McCloskey believes that at most, with the largest possible imperfection elimination, we would only have seen income raised by 0.18 percentage points per year between 1870 and 1913. They come up with different figures depending on the assumptions they make about whether marginal return would be constant, increasing or decreasing and whether social and private returns were aligned.

On the other hand, Keynes (1910), gives us a point of support for capital exports claiming that British investment abroad were “directed towards developing the purchasing power of our principal customers, or to opening up […] our main sources of food and raw materials”. This point, whilst not refuting the argument that higher growth at home could have been achieved by capital domestic retention, points out that there were benefits in exporting capital abroad because British consumers gained from lower food and raw material prices as a result of British investments in railway projects (40% of loans throughout the period were spent on railways – Pollard) which accessed new frontiers of cultivated lands. Without British investments abroad promoting this, consumers may have faced higher food and raw material prices, which would mean they have less to spend on other goods such as manufacturing items. Hence, it could be claimed that such investment abroad was good in this case as it stimulated British consumer demand for manufacturing goods, a large proportion of which would have been produced within Britain, thus boosting the economy. Furthermore lower food prices would have forced an increase in productivity within Britain’s domestic agricultural sector (firms would need to buck up or shut down), which may have released more resources for other firms – such as manufacturing – to utilise and expand production with.

Fundamentally these lower prices would have reduced the costs for British manufacturing firms which would give them a competitive edge – although it may have been the case that this advantage would have been available to Britain’s competitors also thus meaning British investment had a positive externality. Regardless of whether Britain got a competitive edge on this basis it is still the case that lower manufacturing prices would have meant a higher demand. Additionally, this investment abroad would have increased the income of foreign citizens, some of which would have worked its way back to Britain. This is particularly pertinent for steel and railway construction, whereby capital exported abroad to construct railways resulted in demand for British steel, thus boosting British incomes as a result of this foreign investment.

In support of this argument, Rowthorn and Solomou find that a 1% change in overseas income raised aggregate consumption by 0.027% through the absorption effect, whilst also finding that the Dutch disease effect was unlikely to be that prevalent during the period. This absorption effect occurs because higher investment income leads to increased consumption by wealth holders at home who either demand more imports or reduce the amount available to export. Either way, this would benefit national income – more imports would lower the real exchange rate and so make British goods more competitive, ceteris paribus, increasing their demand; and a greater domestic demand has a more direct effect in increasing incomes.

Within some of the literature it is argued that British firms lost out because the financial district of London didn’t take an interest in their situation and was biased towards exporting capital. Edelstein refutes this, believing that London being isolated from provincial affairs “stemmed from the ability of provincial capital markets and wealth to satisfy home industry’s then generally small scale needs cheaply and flexibly” which, if true, would mean that British firms wouldn’t have benefitted tremendously from more capital being kept at home.

An interesting observation was made by Dimsdale, who believes that the demographic changes led to a rise in the savings rate which enabled high capital exports without reducing the rate of domestic investment. Whilst, this doesn’t detract from the argument that these higher savings could all have been channelled domestically, it does diminish the belief that foreign investment necessarily displaces domestic investment. This explains the stability in the rate of growth of the domestic capital stock (Matthews et al 1982) despite the rapid rate of accumulation of overseas assets.

In conclusion there is little evidence to suggest that the economy was seriously negatively affected by capital exports. Whilst certain commentators have shown mathematically that incomes could have been higher had capital exports been kept at home, these are counterfactuals and as such are not conclusive figures – it may have been the case that capital being kept at home would have resulted in eventualities which actually reduced the growth of the economy. Even within these unsure mathematical models there is large disagreement about whether the economy could have done any better – was it at its capacity? The answer to this depends on the assumptions we make within our simplified models and as such they give us an incomplete answer. Whilst social and private returns didn’t align completely (due to the British subsidy for Empire) the fact that investors maximised their returns by seeking out the higher rates must have meant that incomes were almost as high as possible. If this wasn’t the case then it would have been profitable to invest domestically and the competitive nature of the British economy would have resulted in this occurring. In addition, we have explored the indirect benefits to capital export, such as cheap food and raw material prices which were good for consumers in multiple ways, it may also be the case that Britain gained political soft-power from its investments, something of which the benefit is difficult to quantitatively evaluate.

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